Month: October 2013

Robert Shiller, Nobel Laureate

Robert Shiller spent much of his career at Yale University.  He is a famous economist for his analysis of speculative bubbles and price overreaction to new information, first in stock markets and then later in real estate markets.  He has been a leading candidate for a Nobel Prize for some time now.

Here is Shiller’s home page.  Here is Shiller on Wikipedia.  Here are short columns by Shiller on Project Syndicate.  He also writes regularly for the Sunday New York Times, and some of his columns are here.  Here is a 2005 David Leonhardt profile of Shiller.

Shiller’s most famous piece is from 1981, “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?”  Here Shiller developed the very important “variance bounds test” for scrutinizing the rationality of stock prices.  The intuition runs like this.  Let’s say you were trying to forecast the result of Miami Heat vs. San Antonio Spurs.  The results of the actual games would show higher variance than your forecast, which would reflect your single best guess of which team is better.  But in reality sometimes Miami will win, sometimes the Spurs will win, by a little, by a lot, etc.   That is a basic principle of forecasting rationality, in other words that actual outcomes should show higher variance than forecasts.  But now consider stocks.  According to Shiller, the “actual results” — namely the realized returns — are the dividends.  The forecasts of the dividends are stock prices.  Yet dividends hardly vary, while stock prices move around a great deal.  It would appear that stock prices violate this variance bounds test because the forecast has a higher variance than the actual outcomes.  (For some push back on this, see the papers by Allan Kleidon from the 1980s.  For non-stationary time series for instance a variance bounds test may not hold because the population variance, as opposed to the sample variance, is infinite and thus undefined.  Another point is that stock prices may move because the stock is an option on the real assets of the firm, which have changing value, whether or not dividends ever vary and of course dividends are consciously smoothed.)

Shiller also extended his variance bounds test to the term structure of interest rates, for instance in his work with John Campbell.  Think of long rates as being forecasts of future short rates.  According to a variance bounds test, the long rates should be less volatile, but in market data we generally observe the opposite.  This again raises the possibility that markets are overreacting to new information rather than estimating values rationally.

You will note that some of Shiller’s models imply systematic returns to betting against the market and expecting some long-run mean reversion.  If the market is overreacting to new information right now, over some longer time horizon it will have to return closer to fundamental values.  So if you, as an investor, have enough patience, you should (on average) bet against short-term market movements.  Of course this hypothesis has received a good deal of empirical testing and perhaps there is some (slight) long run mean reversion, although it is not clear how much those gains can be captured after transactions costs are paid.  In any case, there may be some excess returns to buying right after prices have fallen, contrary to what a strict interpretation of efficient markets theory would suggest.

Shiller’s 1984 piece, “Stock Prices and Social Dynamics,” with Ben Friedman, started laying out a “trends” and “fads” approach to stock and also housing prices.  This integration of psychology and economics might help explain why markets appear to overreact to short-term information.

One intriguing side of Shiller is his advocacy of derivatives and prediction markets to help individuals better hedge risk.  On that see Shiller’s book Finance and the Good Society.  Shiller for instance would like to see explicit futures or forward markets in gdp, and individuals could hedge with those markets to bet against bad business prospects.  One also can imagine laborers insuring their future income by transacting in indicators of economic health.  Shiller has raised the idea of using housing price indices to help hedge against home price risk, whether for future sellers or future buyers.  This aspect of Shiller’s thought has perhaps disappointed some of his fans who have wanted him to take a more critical attitude toward finance.  Shiller instead thinks that a properly reconstituted financial sector could bring the world very significant gains, typically through superior risk hedging.  It remains a general puzzle why so many of these markets continue not to exist, and when they are sometimes started up, they fail to attract sufficient liquidity.

Shiller’s greatest practical contribution is the Case-Shiller housing price index, described by Wikipedia like this:

The Standard & Poor’s Case–Shiller Home Price Indices are repeat-sales house price indices for the United States. There are multiple Case–Shiller home price indices: A national home price index, a 20-city composite index, a 10-city composite index, and twenty individual metro area indices.

This index has become a staple of real world financial analysis and discussion and it is reported in the financial press on a regular basis.

Shiller is also famous for having predicted the housing price bubble which played an important role in America’s Great Recession.  Here is one of his early pieces on that issue.  One of his research innovations was the common sense idea of simply asking home buyers what kind of future price gains they were expecting and then analyzing whether those expectations were realistic (hint: they weren’t).

Here is an on-line course with Shiller, on finance.

Eugene Fama Nobelist

As an undergraduate Fama worked for a stock forecasting service and he was tasked with coming up with rules to make money in the market. Time and time again he would find profitable rules only to find that they didn’t work in new data or out of sample. In graduate school he started talking to Merton Miller, Lester Telser, and Benoît Mandelbrot and finally hit on the idea that in an efficient market price changes would not be forecastable. The rest is history.

Fama’s dissertation and famous 1970 review article, Efficient Capital Markets: A Review of Theory and Empirical Work made efficient markets a touchstone for modern economists and finance theorists but practitioners hated and still hate the idea. Nevertheless, test after test showed that very few mutual fund managers beat the market and those that beat the market this year are not more likely to beat the market the next year. Chance and perhaps a few, very rare, geniuses explain the data. Eventually, hundreds of billions of dollars began to flow into index funds and today index funds manage over $7 trillion dollars worth of assets worldwide, making Fama the 7 trillion dollar man. Fama’s ideas have made an enormous contribution to how people invest, saving them billions in fees which generated beautiful homes for fortunate mutual fund managers but less than nothing for their customers.

The no free lunch principle is the most robust of the findings of the early Fama/efficient markets school. Other early findings such as non-forecastability of returns have been revised. The initial finding was that returns were not forecastable and that is true for short durations but it is now clear that returns can be forecastable over longer horizons! In particular, variables such as the dividend/price ratio can predict stock return variation years in advance! (Robert Shiller pioneered many of these kinds of studies as did Campbell and Cochrane).  Fama, however, contrary to how he is sometimes represented did not reject these findings. Indeed, the less well known part of the story is that Fama working with French (e.g. Fama and French (1988a,1988b, 1993) has been among the pioneers in documenting and explaining these findings. What Fama’s later work has shown is that many of the anomalies such as time varying returns and the higher return to so-called value firms are real but they are not anomalies they are better explained as variations in risk premia tied to changes in the business cycle.

The CAPM (for which Markowtiz and Sharpe won the Nobel) suggested that the only source of true (priced) risk was risk that varied with the market return. That is one important source of risk but it’s not the only one, other types of macro risk which appear to vary with the business cycle are also priced and they are correlated with markers like the dividend/price ratio and the prospects for value and small-cap stocks. Thus, Fama showed that many of the seemingly anomalies (not all, however!) of the early efficient market tests can be better explained by a market model that incorporates more sources of risk. All of this work has really been a tour de force. It’s not often that the same person creates the theory and then participates in the first revolution overturning (some of) that theory.

Fama also pioneered the first event study! Fama, Fisher, Jensen, and Roll (1969) studied something a bit prosaic, stock splits, but the methodology, looking at how the stock market reacts to unexpected events, has seen been used to study what happens when Senators die unexpectedly (firms they support fall), what happens in close elections, which part was responsible for the Challenger space shuttle crash and many other events.

Eugene Fama, Nobel Prize Laureate

Fama has been long-deserving for some time now.  He won basically for his empirical work on asset prices.

Here is Fama on Wikipedia.  Here is Fama on

Fama teaches at the Booth School of Business at the University of Chicago and he is very much in the classic mold of a Chicago School economist.  I feared that with the financial crisis Fama would be too unpopular a pick, because many people misinterpret “efficient markets theory,” so this was a prize which valued the economic impact of the research over the trendiness.  That said, giving the prize to Shiller as well is a nod in the direction of behavioral finance and inefficient markets theory, so the committee covered all the bases.

Fama’s first key piece dates from 1965, and then through the 1970s he laid down the foundations for tests of efficient markets theory.  The bottom line to these early tests is that publicly available information does not predict excess returns.  That does not mean market prices have to reflect fundamental values of stocks (though Fama sometimes flirts with that claim too), but it does suggest that stock-picking, in the absence of information, will not on average outperform diversification plus random stock purchases.  The variables which earlier theorists thought might predict excess returns turn out not to.  Here is a good survey article, with Burt Malkiel, on where the efficient markets hypothesis stood circa 1970.

The remarkable thing about Fama — and a point which critics often neglect — is that Fama, working with Ken French, also has provided some of the best evidence against the efficient markets hypothesis.  See for instance this 1992 piece.  And see this piece too, with French from 1993.  Contrary to the earlier Fama work, it turns out there are some empirical predictors of excess returns, if you look hard enough for them.  The most notable of these are firm size and book to market value.  To put that more concretely, small firms, when they sink in market valuation relative to their book values, appear to yield excess returns in the future periods.  In this regard Fama’s later work is closely in tune with some of the later research by Robert Shiller.  One possible way of reading this empirical result (which I believe by the way Fama has never endorsed) is that the share prices of small firms show some mean-reversion upwards after they are hit by bad news; that could result for instance from imperfect liquidity in those share markets, combined with some measure of contagious investor sentiment.

The 1992 and 1993 pieces with French are landmarks in empirical finance and they set off a much longer literature trying to find predictors of excess returns on stocks.  Note that Fama holds open the possibility that real rates of return are changing in the economy, or risk premia are changing, and thus he does not automatically identify these empirical results with market inefficiency, as he had defined that concept in his articles from the 1960s.

Perhaps surprisingly, many of Fama’s best cited pieces are on organizations, control, and property rights, in the vein of Ronald Coase.  These pieces are not what won him the prize, but he provided an early and very insightful typology and analysis of different organizational forms, such as limited liability, non-profits, publicly vs. privately-held firms, and so on.  With Jensen he wrote a seminal piece on the separation of ownership and control, and why transactions costs might give rise to such organizational forms.  I am a big fan of his 1980 piece “Agency Problems and the Theory of the Firm.”  One contribution of this article is to show how the market for managers can boost firm efficiency, even when takeovers and other ways of disciplining managers are working imperfectly.  Also see his “Agency Problems and Residual Claims,” again with Jensen.  Fama’s work on organizational forms tends to suggest that observed market structures work relatively well, for reasons related to the work of Ronald Coase and transactions costs.

Fama has many other contributions.  He wrote an insightful piece asking what is special about banks.  It could be that deposit-taking banks have special information about the businesses they are dealing with.  This was a very important piece about inflation and stock returns.  Finally, one of Fama’s 1980 papers suggested that control of currency would suffice to pin down the price level and also control aggregate demand.  This piece continues to exert a strong influence on our own Scott Sumner, who argues that currency will suffice to achieve a nominal gdp target, even when credit markets are not operating very well (I don’t agree with that claim, by the way).

It is remarkable how many top flight, empirically important, and conceptually sharp pieces Fama contributed from 1965 through the mid 1990s, pretty much a thirty year period.  And after that he hardly fell apart in terms of research.  This is a very well deserved Nobel Prize.

Here is a fun New Yorker interview with Fama.  Here is Fama’s home page.  He is also an avid golfer.

Natural experiments from Washington State?

Washington already has the highest state minimum wage in the country, at $9.19 an hour. Soon, voters in this tiny city south of Seattle will decide whether to push the local minimum even higher.

If a majority of the voters here say yes to a referendum known as Proposition 1 when their mail-in ballots start arriving this week, a minimum wage of $15 an hour would be required for many businesses in SeaTac, more than twice the federal minimum of $7.25.

There is more here.  Of course doing this in a single locality is the least advantageous setting for such a policy experiment.  That said, the Sea-Tac airport (and associated concerns) is by far the biggest employer in the city and that entity may well face inelastic consumer demand in response to higher prices, provided those price hikes can be collectively enforced across all the sellers in the airport, which is indeed what a minimum wage hike would bring.

My longstanding quest for the ideal bibimbap

Since the mid nineties I have been looking for a bibimbap that would stand above all others.  A year ago I found it in Seoul, and yesterday I retraced my steps and visited again.

As I entered, the woman in charge appeared to recognize me and gave me a stoic look of “Oh, you again.”

This is vegetarian bibimbap, with egg, and you need to shake your lunch box many times.  She will do it for you.  They also serve a superb bean sprout and seaweed and rice noodle soup, and if that description doesn’t excite you, you need to get to Korea as soon as possible.

As a sideline, they sell Korean antique furniture out of the side room.

It is very close to Changdeokgung palace area, up the nearby street (first pass the Hyundai Cultural Center) with lots of shops and restaurants and old Korean roofs.  French people walk there.  I was told by another customer that the address was Jongro Gaedong 44, but on the other side of the street I saw the numbers 91 and 93, in any case this building is just short of The Cup Story and Uncle’s Bob stores.  (02) 744-8130 and 010-9942-9967 are given on the business card.

It is worth visiting Seoul to eat this woman’s food.

And after you finish, it is about a ten minute walk to the Institute of Traditional Korean Food, where they have an excellent rice cake museum.

The new Elizabeth Gilbert book and what makes for an ideal read on a long plane flight?

It’s good — really — and it is called The Signature of All Things.  I also find the book was nearly ideal for a long plane flight.  It has enough ideas to keep one’s interest, as I find that truly schlocky fiction bores me after a short while (it is better for short flights than for long ones).  But it is also easy enough to read and the print is suitably large.

Which other books do you find to be ideal for long plane flights?

Facts about Catalonia

Nationalist leaders claim that an independent Catalonia would be like the Sweden, Netherlands, or Massachusetts of the south of Europe. Although Catalonia is a rich region, it is very far from these benchmark cases. According to an EU study, Catalonia has the worst regional government in Spain in terms of corruption, effectiveness and accountability, with a level comparable only to some regions in Greece, Italy and former Eastern Bloc countries.

Similar to the rest of Spain, the area is suffering from the consequences of economic crisis and political corruption scandals. Its regional government is the most indebted in the country in absolute terms and the third most indebted relative to its GDP. The Catalan government has seen its credit rating slashed by all credit agencies and is unable to finance itself in the markets. In addition to this, an independent Catalonia would automatically exit the EU and would have to renegotiate membership with the threat of a Spanish veto.

Here is more, by José Javier Olivas, via the excellent

The cost of losing when you try brinksmanship

From the essential Robert Costa on Twitter:

Some more info from Senate R convos: Sen Dems are pushing for Reid to include seq fixes in any deal, think GOP is on ropes, shld push

Petard, hoist, etc.  “Seq fixes” by the way means fixes to the sequester, or in this case more government spending.  If you play threat games and lose them, you don’t simply end up back to where you started, rather you become vulnerable to the threats of the other party.  That is yet another reason why these threat games are dangerous.

Costa by the way is the guy to follow on this whole mess.

Gangnam fact of the day

I am here for a few days, so my attention turned to a new paper by Kim and Jung, entitled Investor PSY-chology, here is the abstract:

The global success of “Gangnam Style,” the 18th K-pop single by the South Korean rapper PSY in 2012, was an exogenous shock to international investor enthusiasm about DI Corp., because the company’s chairman and CEO is PSY’s father. The stock price of the semiconductor equipment company jumped by almost 800% in three months without material information. Using Korean microstructure data that identifies non-resident foreign individual (NRFInd, hereafter) investors and resident foreign individual (RFInd, hereafter) investors by nationality, we study international individual investor behavior. The count of flash mob videos and parody videos uploaded on YouTube from each country is our proxy for the enthusiasm of individual investors. We find that NRFInd (RFInd) investors in specific countries become net buyers (sellers) of DI Corp. when a flash mob or parody music video is uploaded in their country. This is because RFInd investors had already purchased the stock on the day PSY left Korea to meet Scooter Braun, the producer of Justin Bieber. Our results support a “resale option” explanation about the bubble in the asset price.

Hat tip goes to @EmanuelDerman.

Assorted links

1. The McDonalds tasting menu.

2. Purva paksha.

3. Some more on those new service sector jobs. “”I bet there are many more people who are unfaithful than are Jewish,” Biderman remembers thinking.”  Washington D.C. is a clear number one for membership.

4. “Your vacuum might rent an attachment from the neighbor’s vacuum without telling you.”

5. Are anti-bullying programs actually “how to” courses?

Will the sports sector ever be disrupted?

Here is a question from a recent symposium:

People spend 4 hours per week watching sports and 40 listening to music. But the music industry is one sixth the size of the sports industry. Why?

No time-shifting for live contests, much less piracy, less substitutability (there is only one Super Bowl), and greater indivisibility of product would be the beginnings of an answer.  The source is here, hat tip goes to Ted Gioia.

How the machines will pick the best workers in the future

From Aki Ito, here is a a good discussion of a new innovation, related to some trends I discussed in Average is Over:

To aid that search [for better workers], Juhl this month will begin using an online video game designed to track, record and analyze every millisecond of its players’ behavior. Developed by Knack in Palo AltoCalifornia, Wasabi Waiter places job-seekers in the shoes of a sushi server who must identify the mood of his cartoon customers and bring them the dish labeled with the matching emotion. On a running clock, they must also clear empty dishes into the sink while tending to new customers who take a seat at the bar.

Using about a megabyte of data per candidate, Knack’s software measures a variety of attributes shown in academic studies to relate to job performance, including conscientiousness and the capacity to recognize others’ emotions. Knack’s clients will also see a score estimating each applicant’s likelihood of being a high performer.

As for another company:

…The patterns gleaned since the company’s founding in 2007 have debunked many of the common assumptions held by recruiters, Evolv executives say. For example, a history of job-hopping or long bouts of unemployment has little relationship with how long the candidate will stay at his or her next job, according to Evolv’s analysis of call center agents.

“As human beings, we’re actually pretty bad at evaluating other human beings,” said David Ostberg, vice president of workforce science at Evolv. “We’re making sure people are using the right data, instead of the traditional methods that were previously thought to be valid but big data’s showing are not.”


New York-based ConnectCubed has also developed software to determine the personality and cognitive abilities of job applicants that, at its largest clients, is tailored for that specific company. ConnectCubed has existing workers at those businesses complete its video games and questionnaires so the behavioral profiles of the star employees serve as a benchmark for who managers should hire in the future.

“When new people apply, you can say, wow this guy has all the makings of our top salesmen,” said Michael Tanenbaum, chief executive officer and co-founder of the service. “These are things that are impossible to measure from a resume, especially with educational backgrounds that are often more determined by socioeconomic status than your innate ability.”

To be sure, Knack and ConnectCubed, which say they can predict high-performers across a broad set of workers, haven’t been around for long enough to track, over time, whether their technologies actually are improving the quality of the employees their clients hire or those businesses’ bottom line.

The article is interesting throughout.

Bob Laszlewski on the ACA exchanges

Based upon my survey of a large number of health plans accounting for substantial market share in the 36 states the federal insurance exchange is operating in, not more than about 5,000 individuals and families signed-up for health insurance in the 36 states run by the Obama administration through Monday.

It is not uncommon for a major health insurer with a large market share to report less than 100 enrollments in the first week.

Reports today say the enrollments continue to trickle in at about the same rate.

Worse, the backroom connection between the insurance companies and the federal government is a disaster. Things are worse behind the curtain than in front of it.

Here is one example from a carrier–and I have received numerous reports from many other carriers with exactly the same problem. One carrier exec told me that yesterday they got 7 transactions for 1 person – 4 enrollments and 3 cancellations.

For some reason the system is enrolling, unenrolling, enrolling again, and so forth the same person. This has been going on for a few days for many of the enrollments being sent to the health plans. It has got on to the point that the health plans worry some of these very few enrollments really don’t exist.

The reconciliation system, that reconciles enrollment between the feds and the health plans, is not working and hasn’t even been tested yet.

When health plans call the special health plan “help desk” they are lucky to get through. When they finally get through, the feds are creating a “help desk ticket” to be researched.

Now, if we are enrolling 20 to 50 people per day per health plan per state through the federal exchange, that might be sort of manageable. But if this thing ever ramps up to thousands of enrollments a day…

In summary, big market share health plans are getting maybe 50 enrollments per day per state from the feds and that little bit of new business is a mess.

The link is here, hat tip goes to virtually everyone in my Twitter feed.